Description

Dentalcorp owns and operates over 530 dental practices across Canada. The business was founded in 2011 by Graham Rosenberg, a partner at Clairvest, a well-regarded Canadian private equity firm. Since its inception, dentalcorp has built an impressive track record by focusing on acquiring mature dental practices with established books of business, all while allowing selling dentists to maintain clinical autonomy. As a result, dentalcorp has become the clear acquirer of choice amongst Canadian dentists. Today, dentalcorp is the largest owner of dental clinics in Canada.

Despite dentalcorp’s success in completing acquisitions, the Canadian dental landscape remains highly fragmented, with over 15,000 independent dental practices in Canada. Not satisfied with dentalcorp’s growth, Graham and the current sponsor consortium looked to further accelerate dentalcorp’s acquisition pace by taking advantage of the strong 2021 public markets to utilize a public share price to assist with financing acquisitions. In May 2021, dentalcorp successfully raised ~C$950 million in an all-primary IPO, in which the current sponsor iteration participated.

Dentalcorp’s initial 2021 debut in the public markets was a success, with shares trading above IPO price all throughout the year. Unfortunately, in 2022, dentalcorp’s public market performance could not be any starker. The combination of a majority controlled, dual share class, low float, levered business, with mixed public earnings performance, has sent dentalcorp into orphan status. Dentalcorp shares have effectively traded straight down all year, declining nearly 65% on a peak-to-trough basis and today, are down ~50% YTD. Dentalcorp shares are currently trading for ~$8.50 with enough volume for the average fund on VIC.  

The most crucial point to emphasize, and the crux of the thesis, is just this past week, on November 21, 2022, dentalcorp announced the commencement of a strategic review process to unlock shareholder value. The press release can be found here: https://www.businesswire.com/news/home/20221121005286/en/dentalcorp-Announces-Commencement-of-Strategic-Review-Process-to-Unlock-Shareholder-Value

I believe this is a real strategic review that will result in an outright sale. Specifically, there are three points in the press release that is worth focusing on:

1. The founder / CEO has explicitly said they have received offers for the business. “Our management team is fully aligned with the Board’s decision to explore options to maximize shareholder value, including in response to unsolicited expressions of interest that have been received”
2. The special committee is compromised of purely independent directors. L Catterton and Graham Rosenberg are the only non-independents on the board. L Catterton owns 40% of outstanding shares and has 28% of votes. Graham owns 5% and, through a dual share class structure, controls 35% of votes. It’s incredibly peculiar that L Catterton has two board members and is not party to the committee. I suspect L Catterton is one of the unsolicited expressions of interest.
3. Three investment banks are acting as financial advisors to the Special Committee. Jefferies is the lead given their healthcare / sponsor relationships. TD and CIBC lead the credit. This deal will likely be financed in the bank market as the public markets are a bit more difficult. The Canadian banks love this credit and have seen it levered ~7.0x in the past. Financing advisors would not be involved in this strategic review if this was just a kicking-the-tires exercise.

So bringing this all together, I believe there is a very high probability this is sold in relatively short order given L Catterton’s pole position. I think we will get at least $11 / share, which I estimate is L Catterton’s cost base for this business, and I think a sophisticated buyer can rationalize a bid in the $12-13 area. If I’m wrong, I believe the current ~$8.50 share price represents good value for this incredibly defensive business, providing for an asymmetric investment opportunity.

To frame this opportunity with some more numbers, at $8.50 per share, I see the business trading for an ~8% unlevered pre-tax yield. This is a business that, year in and year out, should grow at least in line with inflation. Even assuming no operating leverage, that gets us to a REAL ~8% unlevered pre-tax yield. I see this being close to the trough for a highly defensive, large, stable business.

Conversely, recent private transaction precedents in the current market suggest valuations >15x EBITDA. This implies a share price >$12. Therefore, I see upside here of ~40%, while the downside should be minimal given the strong valuation support.

What exactly does dentalcorp do, and how does it make money?

Dentalcorp acquires established Canadian dental clinics. Its main value proposition is that it allows dentists to crystalize the equity they have built in the business while allowing dentists to maintain clinical autonomy. Dentalcorp provides administrative support and operational best practices to newly acquired clinics, albeit the overall profitability improvement is somewhat limited. For context, I estimate dentalcorp improves like-for-like practice margins by 200 bps. Therefore, I don’t want to give you the impression that this is some highly scale-advantaged roll-up which is able to drive significant synergies upon acquisitions. Rather, the success of this roll-up is largely financial. Dentalcorp needs to find the right dentist who has built a successful practice and wants to focus on being a professional dentist instead of a business operator. Once dentalcorp identifies these practices, it can’t pay too much. Individual dental clinic acquisitions have been in the 6-8x EBITDA area, which equates to a stabilized 11-15% pre-tax unlevered yield.

After a clinic is acquired, the dentists stay on for at least five years. Dentists are solely commission-based, paid on billable hours. Asides from rents, the costs within a dental practice are largely variable, with the largest comp line item being dental commissions. Dentalcorp has been acquiring clinics for over ten years, and nearly half of its practices are now 5+ years old. So far, the cohort renewal data looks incredibly strong, in the 95%+ range. The average dentist age at the time of acquisition is 47 years old. Most dentists renew after their original contract before retiring, meaning dentalcorp expects most dentists to serve for ten years under dentalcorp ownership.

Is this a good or bad business?

While the value of having a scaled dental clinic roll-up can be debated, I believe an individual dental practice is an attractive business with predictable, highly recurring, recession-resilient cash flows. This holds particularly true for Canadian dental practices.

The Canadian dental industry is primarily private cash-pay, where the patient must pay the provider at the time of service. If the patient has dental benefits or insurance, the patient is responsible for submitting the claim to their private benefits or insurance provider for reimbursement. This approach differs from other healthcare services sectors across North America where the economic relationship and burden of seeking reimbursement from an insurance company or government payors typically falls on the healthcare provider. This dynamic results in Canadian dental providers having limited exposure to insurance companies / government payment delays and limited days of accounts outstanding. For example, dentists in the United States receive co-pays from patients at the point of service and then are required to submit claims directly to the insurance companies.

~75% of Canadians have dental benefits from their employers. Effectively this means their employers pays the dentist at the time of service. In turn, ~75% of Canadians see a dentist annually, utilizing their benefits. Per capita dental service expenditures in Canada have grown consistently for nearly ~50 years and Canada is the fastest-growing G7 population (entirely immigration driven). Similarly, dental service pricing has historically increased above inflation during almost any inflationary period (see the supporting data in slide 9 from dentalcorp’s most recent investor presentation).

What’s the business worth?

As of Q3-22, net debt outstanding is $923 million. Using an $8 share price (as assumed in the Q3-22 financials), the fully diluted stock outstanding is 185.2 million. At the current $8.50 share price, I see dentalcorp trading for an enterprise value of $2.5 billion.

Current EBITDA (after lease expense) for dentalcorp’s 538 dental practices is $213 million. Therefore, dentalcorp is trading for <12x EBITDA.

Dentalcorp estimates maintenance capex of $30k per clinic and this estimate appears in-line with my checks. This means EBITDA – capex is approximately $195 million, implying dentalcorp is trading for <13x EV / EBITDA – capex. This ~8% pre-tax yield is an attractive valuation for a collection of dental clinics across Canada, which should grow in any economic environment and deliver unlevered earnings growth at least in line with inflation.

Many sell-side analysts point to other acquisitive healthcare companies as comparables to dentalcorp. I don’t place much value on these relative valuations, given how different the business models are (e.g. Surgery Partners, National Vision, etc.). Still, the discount dentalcorp is currently trading to these names is sizeable (3-8 EBITDA turns) and worth noting.

However, what intrigues me most about this dentalcorp situation is the large private transactions for dental networks that have been completed. Most notably, the 123Dentist/Altima Dental transaction merged the #2 and #3 dental players in Canada. The deal was completed in July 2022, so this transaction was in a similar market backdrop to today. While full transaction details are not public, from my understanding, this deal was done at 17x EBITDA, with leverage in the ~8x area. The transaction was backed by notable PE investors such as KKR, Peloton Capital Management, and Sentinel Capital Partners. In addition, a strategic partner, Heartland Dental, was involved in the transaction. Heartland is the largest U.S. dental roll-up. Over $1 billion in actual cash changed hands during this transaction, so this is a real mark. Dentalcorp at the same valuation implies a >$14 share price or ~70% upside from today.  

Other notable private transactions include US Oral Surgery Management which was for ~US$750 million done in the ~15x EBITDA area. In addition, Berkshire Partners’ Affordable Care was valued ~US$2.7B, implying a ~17x EBITDA multiple. These multiples not only support a high Dentalcorp valuation, but I believe the Canadian dental market is more attractive than the US market for the reasons mentioned above.  

Who is L Catterton?

While I could go on painting why I think dentalcorp is undervalued, I think one of the most important points to this situation is an appreciation for just how much L Catterton wants this asset. I’m sure most people on VIC have heard of L Catterton, but for those unaware, L Catterton is the largest consumer-dedicated private equity firm in the world with US$30 billion in AUM. The “L” in L Catterton stems from a relationship the well-regarded Catterton private equity firm formed with LVMH’s Bernard Arnault in 2016. Needless to say, this is not a firm worried about current financing conditions.

L Catterton got involved with dentalcorp in 2018 and currently owns 39.7% of shares outstanding. Despite awe-inspiring operating results over this nearly five-year period, I estimate L Catterton is currently underwater on its shares. Based on the business's equity value at the time of their investment combined with data points from certain option strikes, I estimate L Catterton’s cost base is around ~$11 / share. Most recently, L Catterton participated in the IPO at $14 / share, and there has only been one minor dividend recap since their ownership.

There have been six quarters of results since dentalcorp has gone public. The results have been mixed versus expectations but more or less in the right ballpark. The important takeaway is nothing points to a business that is fundamentally impaired here. What’s obvious, however, is that there is no point in dentalcorp being public. The purpose of the IPO was to give dentalcorp a public currency it could use to consolidate the market faster. In exchange, it would have to operate the business with certain public market constraints, like leverage being below 4.5x (versus ~8x when it was private). Now, dentalcorp is completely stuck as it can’t operate with more leverage in the public markets, all while it’s equity value is trading below a level I think anyone involved in the situation could imagine.

This value disconnect is giving a well-capitalized firm like L Catterton a shot to take back in the business that has more than doubled under their ownership, for the same valuation they initially got involved in. All my checks indicate that L Catterton is aggressively looking to deploy capital in the current market. In turn, I believe L Catterton is the catalyst behind this strategic review and can easily rationalize a bid to take out the minority public shareholders at $11 / share. Recent transaction precedents point to value >$12 / share. At the current ~$8.50 / share, I see substantial valuation support, driving my view that dentalcorp is a highly asymmetric situation.  

Catalyst

acquired